IRS Approves First Group of Certified PEOs under Voluntary Certification Program

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June 5, 2017

Last week, the IRS announced that it issued notices of certification to 84 organizations that applied for voluntary certification as a certified professional employer organization (CPEO), nearly a year after the IRS finished implementing this program (see prior coverage).  The IRS will publish the CPEO’s name, address, and effective date of certification, once it has received the surety bond.  Applicants that have yet to receive a notice of certification will receive a decision from the IRS in the coming weeks and months.

Congress enacted Code sections 3511 and 7705 in late 2014 to establish a voluntary certification program for professional employer organizations (PEOs), which generally provide employers (customers) with payroll and employment services.  Unlike a PEO, a CPEO is treated as the employer of any individual performing services for a customer with respect to wages and other compensation paid to the individual by the CPEO.  Thus, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  To become and remain certified, CPEOs must meet certain tax compliance, background, experience, business location, financial reporting, bonding, and other requirements.

The impact of the CPEO program outside the payroll-tax world has been limited thus far.  For instance, certification does not provide greater flexibility for PEO sponsorship of qualified employee benefit plans.  In the employer-provided health insurance context, the certification program leaves unresolved issues for how PEOs and their customers comply with the Affordable Care Act’s employer mandate (see prior coverage).  While the ACA’s employer mandate may become effectively repealed should the Senate pass the new American Health Care Act (AHCA) after the House of Representatives did so last month (see prior coverage here and here), the AHCA would impose its own information reporting requirements on employers with respect to offers of healthcare coverage or lack of eligible healthcare coverage for their employees.  It remains to be seen if the AHCA becomes law, what information reporting requirements will remain, and how PEOs and CPEOs can alleviate these obligations for their customers.

Recent FAA Serves as Warning to Employers Using PEOs

A recent Internal Revenue Service Office of Chief Counsel field attorney advice memorandum (FAA 20171201F) sounds a cautionary note for employers making use of a professional employer organization (PEO).  The FAA holds a common law employer ultimately liable for employment taxes owed for workers it leased from the PEO.  Under the terms of the employer’s agreement with the PEO, the PEO was required to deposit employee withholdings with the IRS and pay the employer share of payroll taxes to the IRS.  Alas, that was not what happened.

The taxpayer did not dispute that it had the right to direct and control all aspects of the employment relationship and was thus was the common law employer with respect to the employees, but asserted that it was not liable for the unpaid employment taxes. Under the terms of the contracts between the taxpayer and the PEO, the taxpayer would pay an amount equal to the wages and salaries of the leased employees to the PEO prior to the payroll date, and the PEO would then pay all required employment taxes and file all employment tax returns (Forms 940 and 941) and information returns (Forms W-2) with respect to the employees.

After the PEO failed to pay and deposit the required taxes, the Examination Division of the IRS found the taxpayer liable for the employment tax of those workers, plus interest. The taxpayer appealed, making several arguments against its liability: (i) the PEO was liable for paying over the employment taxes under a state statute; (ii) the PEO was the statutory employer, making it liable for the employment taxes; and (iii) the workers were not employees of the taxpayer under Section 530 of the Revenue Act of 1978.

The Office of Chief Counsel first explained that the state law cited by the taxpayer was not relevant because it was superseded by the Internal Revenue Code. The FAA rejects the taxpayer’s second argument because the PEO lacked control over the payment of wages, and thus it was not a statutory employer. The PEO lacked the requisite control because the taxpayer was obligated to make payment sufficient to cover the employees’ pay before the PEO paid the workers.  Finally, the Office of Chief Counsel denied the taxpayer relief under Section 530 of the Revenue Act of 1978 because that provision only applies to questions involving employment status or worker classification, neither of which was at issue.  Although the FAA makes clear that the common law employer will be on-the-hook for the unpaid employment taxes, the FAA did indicate that it would be open to allowing an interest-free adjustment because the taxpayer’s reliance on the PEO to fulfill its employment tax obligations constituted an “error” under the interest-free adjustment rules.

The FAA serves as a reminder that the common law employer cannot easily offload its liability for employment taxes by using a contract. Indeed, it remains liable for such taxes and related penalties in the event that the party it has relied on to deposit them fails to do so timely.  Employers who choose to make use of a PEO should carefully monitor the PEO’s compliance with the payroll tax rules to ensure that it does not end up in this taxpayer’s position.  Alternatively, employers should consider whether to use a certified PEO under the new regime established by Congress (earlier coverage  available here and here).  When using a certified PEO, the common law employer can successfully shift its liability to the PEO and is not liable if the PEO fails to comply with the payroll tax requirements of the Code.

IRS Implements New Voluntary Certification Program for PEOs

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August 15, 2016

Through a flurry of guidance this summer, the IRS has finally implemented the long-anticipated voluntary certification program for professional employer organizations (PEOs).  In 2014, Congress enacted Code Sections 3511 and 7705, which brought about a sea-change in the payroll tax world by creating a new statutory employer: An IRS‑certified PEO (CPEO).  This change is significant because a common law employer (customer) who is otherwise liable for payroll taxes on wages that its PEO pays its employees may shift this payroll tax liability to a CPEO.  In May 2016, the IRS released temporary and proposed Treasury Regulations and Revenue Procedure 2016-33, providing tax and CPEO-certification rules under Sections 3511 and 7705.  After launching the online CPEO application in early July, the IRS proposed to create a new CPEO records system and last week, loosened certain certification rules by issuing interim guidance (Notice 2016-49), on which taxpayers may rely pending final regulations.  Importantly, Notice 2016-49 extended the application deadline from August 31, 2016, to September 30, 2016, for PEOs seeking to have the earliest possible effective certification date of January 1, 2017.

Although the CPEO program is welcomed by PEOs and their customers, applicants and CPEOs must carefully comply with numerous certification rules established under the recent IRS guidance.  Moreover, customers should be aware of limitations on their ability to shift payroll tax liabilities to their CPEOs.  Further, CPEOs and their customers should keep in mind that the CPEO program primarily assists payroll tax administration, and leaves difficult questions regarding CPEO sponsorship of qualified employee benefit plans and compliance with the Affordable Care Act (discussed in a separate blog post).

Background

PEOs provide customer-employers with payroll and employment services.  Before Congress enacted Sections 3511 and 7705 in late 2014, however, customers had remained liable for payroll taxes on wages paid to their employees.  Because there was no rule allowing the tacking of wages, PEOs would have to restart the applicable wage base limitations (e.g., FICA and FUTA limitations) upon moving the customers’ employees to the PEOs’ payrolls.  Under Section 3511, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers, on the other hand, remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  Section 7705 called for the IRS to establish certification requirements.  It also provided a critical enforcement tool:  The IRS will publish every quarter a list of all CPEOs.

On May 5, 2016, the IRS released temporary Treasury regulations establishing certification rules under Section 7705 (temporary regulations).  These temporary regulations became effective on July 1, 2016 and will remain effective for three years thereafter.  Simultaneously, the IRS released proposed Treasury regulations under Section 3511 (proposed regulations) that establish rules on the payroll tax liabilities of CPEOs and their customers.  These rules are likely in proposed form because the IRS intends to revisit numerous issues, such as the treatment of specified tax credits.  Shortly after releasing these regulations, the IRS published Revenue Procedure 2016-33, which provides additional certification and application rules.  Although these rules do not affect an existing PEO’s established practices, a PEO must satisfy the requirements to become certified and thereby attract customers wishing to shift their payroll tax liabilities.

New Certification Requirements

The new IRS guidance establishes a robust set of certification requirements—e.g., proof of suitability, annual financial reporting and positive working capital, bonding requirements, etc.—aimed at ensuring the IRS’s collection of payroll taxes from CPEOs.

Suitability.  The temporary regulations add “suitability” requirements designed to ensure that the PEO has the capability, experience, and integrity to properly withhold and remit payroll taxes.  Showing that it has mulled over the PEO industry and its potential tax pitfalls, the IRS decided to apply many of these suitability requirements not only to the PEOs themselves, but also to certain “responsible individuals,” “related entities,” and “precursor entities” of the PEO.  Thus, for example, the IRS will not certify a PEO solely because its responsible individuals (e.g., certain owners, the CEO, or CFO) have failed to pay applicable Federal or state income taxes or have been professionally sanctioned for misconducts.  Nor can a PEO that is otherwise unsuitable for certification cleanse the taint of prior tax wrongdoings by transferring its assets to a new PEO that applies for certification.

Positive Working Capital & Transition Relief.  The temporary regulations add a positive-working capital rule—tweaked by Notice 2016-49—to ensure that the PEO is financially capable of fulfilling its tax obligations.  Under the temporary regulations, applicants and CPEOs must file annual audited financial statements accompanied by an independent CPA’s opinion that the financial statements (1) are fairly presented under GAAP, (2) reflect positive working capital, and (3) show that the PEO uses an accrual method of accounting.  Addressing comments that CPAs may be professionally prevented from including the last two items in a CPA opinion, Notice 2016-49 provides that, in lieu of doing so, a PEO must include in its annual filing a Note to the Financial Statements stating that the financial statements reflect positive working capital and providing detailed calculations.  Further, Notice 2016-49 provides transition relief for applicants required to submit a copy of its annual audited financial statements and CPA opinion for a fiscal year ending before September 30, 2016.

To allow reasonable fluctuation in working capital, an exception to the positive-working capital rule is available if: (1) the working capital of two consecutive fiscal quarters that year were positive; (2) the PEO explains the reason for the negative working capital; and (3) the negative working capital does not present a material risk to the IRS’s collection of payroll taxes.  The third element hinges on whether the PEO has identified facts and circumstances that will result in positive working capital in the near future.  A similar positive working-capital rule and a similar exception apply to quarterly financial statements.

Bond and Surety.  Under Section 7705(c)(2), an applicant or CPEO must post a bond (ranging from $50,000 to $1 million) with respect to its employment tax liabilities.  The temporary regulations clarified that the bond cannot be substituted with collateral, and that the bond must be issued by a qualified surety, i.e., one that holds a certificate of authority from the IRS.  Accordingly, a CPEO application must include a signed surety letter confirming that the surety agrees to issue a bond pursuant to terms set forth in Form 14751 and in the required amount to the applicant, if and when the applicant is certified.

Business Entity.  The temporary regulations provide that a CPEO must be a “business entity” organized in the United States, but may not be a disregarded entity.  Addressing concerns that PEOs may choose to be disregarded entities for legitimate business reasons, Notice 2016-49 provides that a CPEO may be a wholly domestic disregarded entity.  The Treasury and the IRS sought comments on whether they should allow partly or fully foreign disregarded entity to apply for certification.  Additionally, Notice 2016-49 provides that a sole proprietorship, which is not included in the definition of “business entity,” may apply for certification.

Consent to Disclosure.  Consistent with Section 7705(f), which requires the IRS to publish the names and addresses of all CPEOs, the temporary regulations add that the IRS will also publish the fact of the suspension or revocation of a PEO’s certification and may notify the PEO’s customers of this fact.  Accordingly, the temporary regulations also require an applicant or CPEO to provide the consents for the IRS to disclose confidential tax information to the customers and to other persons as necessary to carry out the purposes of the CPEO rules.

Functional Application of Rule.  The IRS will likely take a functional rather than a mechanical approach to applying the certification rules.  The temporary regulations permit the IRS to suspend or revoke a PEO’s certification if the PEO violates a certification requirement, but require the IRS to do so only if the violation presents a material risk to the IRS’s collection of Federal payroll taxes.  If the IRS suspends or revokes a PEO’s certification, the benefits—e.g., shifting of payroll tax liability and tacking of wages—under Section 3511 will not apply and the PEO must notify its customers of its suspension or revocation.

Employment Tax Treatment of CPEOs and Their Customers

The proposed regulations implement rules under Section 3511 pertaining to the employment tax treatment of CPEOs and their customers.

Work Site Employee.  Section 3511 shifts a customer’s payroll tax liability with respect to wages paid to a “work site employee,” and the proposed regulations apply a quarterly test.  Specifically, a covered employee is a work site employee for a calendar quarter, if at any time during that quarter, at least 85 percent of the service providers at the same work site are subject to one or more CPEO contracts between the CPEO and the customer.

Specified Tax Credits.  The proposed regulations also indicate that the IRS may change its treatment of specified tax credits under Section 3511(d)(1), for which the customer—not the CPEO—is eligible, provided that the wages at issue are paid to a work site employee.  In the preambles to the proposed regulations, the Treasury and the IRS sought comments as to whether they should expand the list of specified tax credits, and how the tax credits should apply with respect to non-work site covered employees.

Continuing Reporting Obligations.  Most significantly, the proposed regulations add three categories of reporting requirements that a CPEO must meet in order to remain certified: (1) reporting to the IRS by CPEOs, including any Form 940 (Employer’s Annual FUTA Tax Return) or Form 941 (Employer’s Quarterly Federal Tax Return) and their applicable schedules, periodic verification of compliance, notice of material changes to information provided, and independent financial review documents, such as the annual audited financial statements along with the CPA opinion; (2) reporting to customers by CPEOs, including notification of suspension or revocation of certification and notification regarding transfer of CPEO contract; and (3) inclusion of certain information in the CPEO contract.

CPEO System of Records

To ensure that an applicant or CPEO complies with the new certification rules, the Treasury and the IRS proposed to establish a records system that covers a myriad of groups of individuals involved in the certification process or administration of the applicant or CPEO.  The proposed records system keeps administrative, investigative, and tax records, which the IRS will only use and disclose consistent with the confidentiality rules under Code Section 6103.  Like the detailed certification rules, the proposed records system signals the IRS’s commitment to enforce the CPEO suitability requirements by weeding out PEOs managed by individuals with a history of tax wrongdoings.  The proposed system became effective on August 10, 2016.

Other Issues

Groundbreaking in the payroll tax world, the CPEO rulemaking project is still in its infancy, and the IRS will continue to issue new rules and clarifications as to a CPEO’s certification and reporting obligations, as well as the new CPEO records system.  Additionally, the IRS will likely address whether to expand the list of specified tax credits applicable to a customer with respect to its work site employees, and how these credits may apply in the case of non-work site covered employees.

One crucial issue the IRS has yet to address is the scope of the liability of CPEOs’ customers.  Although the new rules are intended to shift payroll tax liability to the CPEO, the customer, as the common law employer, may be liable if the IRS retroactively revokes or suspends a CPEO’s certification.  This liability may be significant, as it includes the payroll taxes that should have been but were not properly withheld and/or remitted, and may also include Trust Fund Recovery Penalties.  It is unclear if a customer can avoid this liability when its CPEO failed to withhold or remit payroll taxes properly, solely by showing that it relied on the IRS’s quarterly CPEO list.  Thus, it remains to be seen if the IRS clarifies whether customers must verify their CPEOs’ ongoing compliance with certification requirements.

IRS Certified PEO Program Leaves Unresolved Qualified Plan and ACA Issues

The IRS recently implemented the voluntary certification program for professional employer organizations (PEOs) (discussed in a separate blog post).  Earlier this summer, the IRS released temporary and proposed Treasury regulations and Revenue Procedure 2016-33 pursuant to Code Sections 3511 and 7705, which created a new statutory employer for payroll-tax purposes: an IRS-certified PEO (CPEO).  Last week, the IRS released Notice 2016-49, which relaxed some of the certification requirements set forth in the regulations and Revenue Procedure 2016-33.

Although a significant change in the payroll tax world, the new CPEO program does not clarify the issue of whether a PEO or its customer, the worksite employer, is the common law employer for other purposes.  Thus, even when properly assisted by CPEOs, customers may still be common law employers and must plan for potential liability accordingly.  Two key areas of potential liability are PEO sponsorship of qualified employee benefit plans and the Affordable Care Act’s employer mandate.

PEO Sponsorship of Qualified Plans

Before the new CPEO program became available, the PEO industry was already expanding, with customers pushing for PEOs to act as the common law employers for all purposes, not just payroll tax administration.  Customers particularly sought PEOs to sponsor qualified benefit plans for the customers’ workers.  This arrangement, however, clashed with a fundamental rule of qualified plans under ERISA and the Code:  Under the exclusive benefit rule, employers can sponsor qualified plans only for their common law employees and not independent contractors.  Many PEOs set up single employer plans, even though customers – not PEOs – usually had the core characteristics of a common law employer:  Exercising control over the worker’s schedule and manner and means of performing services.

In Revenue Procedures 2002-21 and 2003-86, the IRS reiterated its hardline stance on enforcing the exclusive benefit rule against PEO plans, stating that after 2003, PEOs can no longer rely on any determination letter issued to their single employer plans, even if the letter was issued after 2003.  The guidance provided two forms of transition relief available until 2003: (1) a PEO could terminate the plan, or (2) convert the plan into a multiple employer plan (MEP), which is an employee benefit plan maintained and administered as a single plan in which two or more unrelated employers can participate.  This MEP option, however, still treated customers as the common law employers, who are subject to nondiscrimination, funding, and other qualified-plan rules under ERISA and the Code.

The new CPEO program does not affect the exclusive benefit rule or the determination of common law employer status for qualified plan purposes.  Certified or not, a PEO can sponsor MEPs, but properly sponsoring any single-employer plan rests on the argument that the PEO is the common law employer.  Thus, the law still significantly limits a customer from outsourcing its qualified plan to a PEO.

ACA Employer Mandate & PEO-Sponsored Health Plan

The Affordable Care Act (ACA) imposes on employers with 50 or more full-time equivalent (FTE) employees the “employer mandate,” which, in turn, applies a tax penalty if the employer chooses not to provide health care insurance for its workers.  In general, the common law employer is required to offer coverage to its employees.  Under some circumstances, however, the common law employer can take credit for coverage offered by another entity—such as another company within the same controlled group.

The problem for PEO customers stems from a provision in the final regulations on Section 4980H.  The provision allows the PEO’s customer to take credit for the PEO’s offer of coverage to the customer’s workers only if the customer pays an extra fee:

[I]n cases in which the staffing firm is not the common law employer of the individual and the staffing firm makes an offer of coverage to the employee on behalf of the client employer under a plan established or maintained by the staffing firm, the offer is treated as made by the client employer for purposes of section 4980H only if the fee the client employer would pay to the staffing firm for an employee enrolled in health coverage under the plan is higher than the fee the client employer would pay the staffing firm for the same employee if that employee did not enroll in health coverage under the plan.

The preamble to the regulations doubles down by describing a situation in which the staffing firm is not the common law employer as the “usual case.”

This extra-fee rule puts the PEO’s customer in a difficult position.  If it does not pay the extra fee, then the PEO’s offer of health coverage cannot be credited to the customer.  Thus, the customer risks being subject to the tax penalty, if upon audit the customer is determined to be the common law employer (assuming the PEO’s customer is an applicable large employer).  Alternatively, if the customer pays the extra fee to hedge against the risk of the tax penalty, the payment could be taken as an admission that the customer—not the PEO—is the common law employer.  Being the common law employer could expose the PEO’s customer to a host of legal liabilities, including, for example, rules pertaining to qualified plans (e.g., funding, nondiscrimination), workers compensation, and respondeat superior.  This result is unacceptable for many customers, who take the position that they are not the common law employers for any purpose.  Unfortunately, the new CPEO program only allows the customer to shift its payroll tax liabilities, and does not affect whether the customer or the CPEO is the common law employer for other purposes.

Finally, there is also a reporting wrinkle for customers outsourcing their health coverage obligations to PEOs.  The ACA requires the common law employer to report the offer of coverage on Form 1095-C.  If the PEO’s customer is the common law employer, there is no rule allowing it to shift this reporting obligation to the PEO.  Thus, if the PEO, rather than the customer, files the Form 1095-C, the customer may be subject to reporting penalties for failure to file a return.

U.S. District Court Finds Taxpayer Had Reasonable Basis for Classifying Workers as Independent Contractors

In an area IRS auditors are increasingly scrutinizing, a U.S. district court sided with the taxpayer in its claim for an employment tax refund on the grounds that the taxpayer had a reasonable basis for classifying its workers as independent contractors and thus was not liable for back employment taxes.  In Nelly Home Care, Inc. v. United States, the IRS asserted after an audit of a homecare services company that the company had misclassified its workers as independent contractors and assessed back employment taxes owed as a result of the misclassification.  Refund claims for employment taxes are within the jurisdiction of the U.S. district courts, so the taxpayer paid the taxes and filed a refund action in the U.S. District Court for the Eastern District of Pennsylvania.

The calculation of FICA and federal income tax withholding in reclassification cases is determined under the special rates of Section 3509 of the Internal Revenue Code when an employer incorrectly classifies an employee as an independent contractor but issues a Form 1099-MISC. The court noted that IRS auditors are increasingly relying on this section to scrutinize worker misclassifications.  However, Section 530 of the Revenue Act of 1978, which was never codified, provides a safe harbor for taxpayers that owe back employment taxes due to worker classification errors.  An employer may qualify for the safe harbor by showing that it had a “reasonable basis” to not classify workers as employees, provided the basis arose from reliance on one of four conditions: (i) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (ii) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment of workers in substantially similar positions to the workers at issue; (iii) longstanding recognized practice of a significant segment of the industry in which the worker was engaged; or (iv) any other factors that a court considers sufficient to establish a “reasonable basis.”

The taxpayer in Nelly Home Care argued unsuccessfully that it satisfied the second and third conditions as a basis for its reasonable belief. However, the court found that the record demonstrated that the taxpayer satisfied the fourth condition for demonstrating that it had a reasonable basis and, therefore, was relieved of the employer’s responsibility to withhold income taxes on and apply FICA taxes to the payments.  Specifically, the court considered the inquiries made of other companies’ practices, the personal experience of the taxpayer in the industry, and the IRS’s silence regarding the taxpayer’s classification during its audits of the owner’s personal tax returns.  Notably, the court warned that its decision “in no way endorses” the taxpayer’s classification of its workers as independent contractors.

IRS To Implement Certification Program For Professional Employer Organizations

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May 5, 2016

Today, the IRS released temporary and proposed regulations implementing a new voluntary certification program for professional employer organizations (PEOs).  These regulations set forth the application process and the tax status, background, experience, business location, financial reporting, bonding, and other requirements PEOs must meet to become and remain certified.  The IRS will begin accepting applications for CPEO certification on July 1, 2016, and will release a revenue procedure further detailing the application process in the coming weeks.  We will provide more details on the regulations when we have had the opportunity to review them.

IRS Issues Regulations Relating to Employees of Disregarded Entities

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May 5, 2016

Yesterday, Treasury and the IRS released final and temporary regulations under Section 7701 meant to clarify issues related to the employment of owners of disregarded entities.  In 2009, the IRS issues regulations that required disregarded entities be treated as a corporation for purposes of employment taxes including federal income tax withholding and Federal Insurance Contribution Act (FICA) taxes for Social Security and Medicare.  The regulations provided that a disregarded entity was disregarded, however, for purposes of self-employment taxes and included an example that demonstrated the application of the rule to an individual who was the single owner of a disregarded entity.  In the example, the disregarded entity is treated as the employee of its employees but the owner remains subject to self-employment tax on the disregarded entity’s activities.  In other words, the owner is not treated as an employee.

Rev. Rul. 69-184 provides that partners are not employees of the partnership for purposes of FICA taxes, Federal Unemployment Tax Act (FUTA) tax, and federal income tax withholding.  This is true even if the partner would qualify as an employee under the common law test.  This made it difficult—if not impossible—for partnerships to allow employees to participate in the business with equity ownership such as options even if the employee owned only a very small portion of the partnership.  The 2009 regulations raised questions, however, provided some hope that a disregarded entity whose sole owner was a partnership could be used to as the employer of the partnership’s partners. Doing so would have allowed partners in the partnership to be treated as employees of the disregarded entity and participate in tax-favored employee benefit plans, such as cafeteria plans.  The final and temporary regulations clarify that that an individual who owns and portion of a partnership may not be treated as an employee of the partnership or of a disregarded entity owned by the partnership.

As a result, payments made to partners should not be reported on Form W-2, but should be reported on Schedule K-1.  Such payments are not subject to federal income tax withholding or FICA taxes, but will be subject to self-employment taxes when the partner files his or her individual income tax return.  In addition, if partners are currently participating in a disregarded entity’s employee benefit plans, such as a health plan or cafeteria plan, the plan has until the later of August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016.

Tax Court Lacks Jurisdiction to Review IRS Employment Classification Determination

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April 5, 2016

Today, the U.S. Tax Court held that it lacked jurisdiction to review a Form SS-8 determination that a father was an employee, not an independent contractor, of his son. In B G Painting, Inc. v. Commissioner, the son, a painting contractor, issued Forms 1099-MISC to his workers, including the father. The father filed a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding), requesting that the IRS determine his employment status. In response, the IRS SS-8 Unit notified the parties that the father is the son’s “employee.” The son petitioned the court to review this determination.

The Tax Court held that it lacked statutory jurisdiction to review this determination because the Form SS-8 process is not an “examination.” Section 7436(a) of the Internal Revenue Code grants the Tax Court jurisdiction over employment status if “in connection with an audit of any person, there is an actual controversy involving a determination by the Secretary as part of an examination.” But the Form SS-8 process is not an “audit” or “examination”; rather, it is a voluntary compliance process involving no specific tax liabilities or assessments. Therefore, the Tax Court dismissed the case for lack of jurisdiction.

Once the IRS rules that an individual is an employee on the basis of a Form SS-8 submission, the employer has no right to appeal the determination. The IRS will send a follow-up letter to the employer asking whether the employer has filed Forms 941-x to pay the applicable FICA taxes based on the determination, whether the employer is eligible for Section 530 relief, and whether the employer has reasons for believing the IRS determination is incorrect. Given the obligation to provide health insurance to employees or face a potential tax penalty, the employer should expect an increased number of Form SS-8 submissions by independent contractors and increased focus on worker classification issues by the government.

If the employer fails to treat the individual as an employee following a Form SS-8 determination, the individual may file Form 8919 to report his or her share of FICA taxes. The same form can be used while a Form SS-8 is pending for the individual or if the individual was provided both a Form 1099-MISC and a Form W-2 and believes the income reported on the Form 1099 should have been included on Form W-2.